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Ssrn id1113888

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1 Policy Brief2008-PB-04March 2008The Subprime Crisis -- Cause, Effect and ConsequencesR. Christopher WhalenAbstract: Despite the considerable media attention given to the collapse of themarket for complex structured assets that contain subprime mortgages, there has beentoo little discussion of why this crisis occurred. "The Subprime Crisis: Cause, Effect andConsequences" argues that three basic issues are at the root of the problem, the first ofwhich is an odious public policy partnership, spawned in Washington and comprisinghundreds of companies, associations and government agencies, to enhance theavailability of "affordable housing" via the use of "creative financing techniques."Second, federal regulators have actively encouraged the rapid growth of over-the-counter (OTC) derivatives and securities by all types of financial institutions. And third,also bearing blame for the subprime crisis is the related embrace by the Securities andExchange Commission (SEC) and the Financial Accounting Standards Board of "fairvalue accounting." After reviewing the Bush administrations proposed solutions asflawed, this article recommends a strategy for subprime crisis resolution. Job one is torebuild market confidence in structured assets by going back to "first principles" onissues such as market transparency, standardization of contracts, and accountingtreatment. By reducing complexity on the trade of structured assets through simpledeal structures and providing investors with the information they need to analyzecollateral, for example by requiring SEC registration and public pricing of assets, muchof the current liquidity problem is ameliorated.About the Author: Richard Christopher Whalen is co-founder and managingdirector of Institutional Risk Analytics. Mr. Whalen edits The Institutional Risk Analystcommentary and represents IRA in various risk management and technical forums. Hehas worked as a journalist and investment banker for more than two decades and hasadvised government agencies and corporations from the U.S., EU and Japan onfinancial and political risks around the world.Keywords: Subprime crisis, affordable housing OTC derivatives, fairvalue accounting, structured assets.The views expressed are those of the individual author and do not necessarily reflect official positions of Networks FinancialInstitute. Please address questions regarding content to Christopher Whalen at cwhalen@institutionalriskanalytics.com. Anyerrors or omissions are the responsibility of the author.NFI working papers and other publications are available on NFI’s website (www.networksfinancialinstitute.org). Click“Research” and then “Publications/Papers.” Electronic copy available at: http://ssrn.com/abstract=1113888

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2The Subprime Crisis -- Cause, Effect and ConsequencesR. Christopher Whalen "The new group at the Fed is not equal to the problem that faces it. They need to speak frankly to the market and acknowledge how bad the problems are, and acknowledge their own failures in letting this happen. This is what is needed to restore confidence. There never would have been a sub-prime mortgage crisis if the Fed had been alert. This is something Alan Greenspan must answer for." Dr. Anna Schwartz The Sunday Telegraph January 14, 2008Subprime Crisis: CausesDespite the considerable media attention given to the collapse of the market for complexstructured assets, some of which contain subprime mortgages, there has been precious littlediscussion of why this crisis in confidence occurred and in particular why some $3 trillion inprivate label structured assets are being liquidated, with negative effects on banks, dealers, endinvestors and the economy. Such a discussion, which is the primary goal of this paper, willhopefully lead members of the financial community to consider how the market for structuredassets should change and evolve in future. iThe failure of Bear, Stearns & Co (NYSE:BSC) last week is just the latest in a series of failurescaused by a global process of de-leveraging. The private market for complex structured assets,particularly the $1 trillion or so of face amount that contained subprime mortgages at the start of2008, arguably can trace its origins to the market for agency debt, particularly paper issued bygovernment-sponsored entities (GSEs) such as Fannie Mae and Freddie Mac. The collapse ofthe subprime market is attributable to many factors, but three basic issues seem to be at the rootof the problem. • First, an odious public policy partnership — the National Homeownership Strategy -- spawned in Washington and comprising hundreds of companies, banks, associations and government agencies — to enhance the availability of "affordable housing” via the use of “creative financing techniques.” ii • Second, active encouragement by the SEC and federal bank regulators of the rapid growth of over-the-counter (OTC) derivatives and securities by all types of financial institutions, leading to a breakdown in safety and soundness at banks and securities dealers. Electronic copy available at: http://ssrn.com/abstract=1113888

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3 • And third, the related embrace by the Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board (FASB) of “fair value accounting,” an ill- advised change in reporting standards for all public companies that is arguably driving much of the current panic on Wall Street.Affordable HousingThe partnership for affordable housing was the creation of the real estate, home building andGSEs lobbies, relying upon legal mandates such as the Community Reinvestment Act (“CRA”)to “encourage” the banking industry to target increased home ownership in the U.S.. It beganafter the real estate collapse of the late 1980s, when the savings and loans (S&L) industry wasalmost entirely de-capitalized and real estate prices in many parts of the U.S. saw double digitdeclines. The housing GSEs were effectively insolvent by 1991, but the implicit guarantee bythe U.S. Treasury enabled them to survive and expand their activities.The methods used by the partnership to garner political support were, not surprisingly, similar tothose employed by GSEs such as Fannie Mae and Freddie Mac on Capitol Hill. Support for“affordable housing” became a key part of local and national politics, aided by copious“donations” from the GSEs to members of Congress, a fact that lenders and real estatedevelopers used to great advantage.Banks, for their part, saw the affordable housing push as a way to placate and/or gratifypoliticians and community activists, and also to meet visibly CRA requirements for makingcredit available to minorities. CRA loans, let us not forget, have 100% loss rates and arefunctionally equivalent to political campaign contributions.By the early part of the 21st century, nearly every mortgage lender in the U.S. incorporated thetwin messages of “affordable housing” and “creative financing” into marketing, credit approvaland product development efforts. The home builders and realtors were also an important part ofthe affordable housing push, exerting political influence to gain government support for housinggoing pack three decades to the 1970s. Then as now, boosting home ownership and homebuilding was seen as a way to stimulate a sluggish economy.Washington consultant Robert Feinberg said in a March 2008 interview: “[In the 1970s] heredeveloped what I call the Homebuilder-Realtor-Mortgage Banker Industrial Complex. Theycreated a mythology that said you could not have enough housing and it was up to thegovernment to make sure that happened. The home builders had a quota of 2 million units thathad to be constructed every year. They really didnt care what happened to those homes oncethey were built.” iiiAt a meeting at the Harvard Club this past September, Josh Rosner, a principal of Graham Fisher& Co., noted that the partnership for affordable housing helped push structural changes in thehousing industry, which ultimately led to a significant increase in home ownership in the U.S.between the early 1990s (63%) and its peak in 2005 (69%). Said Rosner:

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4 "So what we saw actually was the largest public-private partnership to date, started as the National Partners in Home Ownership in 1994. It was signed onto by the realtors, the home builders, Fannie Mae, Freddie Mac, the mortgage bankers, HUD. It was a massive effort, with more than 1,500 public and private participants, and the state goal was to reach all time home ownership levels by the end of the century. And the stated strategy proposal to reach that goal was, quote: to increase creative financing methods for mortgage origination. Those seeds were sown in 1994. Those policies were put in place in 1994. By 1995 we saw home prices start to rise and home ownership levels also start to rise. How did we do that? There was no private label [mortgage] market at that point. We were really dealing in a world of enterprise [GSE] paper. We saw most of the features [of CDOs and structured assets] that we are now looking at as having been atrocious or irresponsible or poor risk management having started in the enterprise markets. We saw changes in the LTV, changes from manual underwriting to automated underwriting. The approval models used were easy to game. We saw reductions in documentation requirements. We saw changes for mortgage insurance requirements. We saw the perversion of the appraisal process and a move to automated appraisals. All of these features which we now look at and point our fingers at the subprime originators and say you bad boys, all started in the enterprise market. This, by the way, is why I believe there is still significant risk [in the GSEs]." ivRegulatory LapsesThe second factor that helped foment the subprime debacle, strangely enough, is not the liberal,easy money monetary policy followed by the Fed under Chairman Alan Greenspan earlier in thisdecade, but rather errors and omission committed by regulators regarding bank regulatory policy,especially when it comes to bank involvement in securitization. Rosner and others, such asDrexel University professor Joseph Mason, argue that the original model for the subprimemarket was the GSE market and that most of the features of CDOs and complex structured assetsthat we now look upon as irresponsible or poor risk management started in the markets foragency paper. vAcademic texts are filled with various vies of the utopian dream of an efficient, transparent,private securitization market replacing commercial banks as a means of raising capital.Unfortunately, this vision was simply carried further by Wall Street than anyone in the Congressor the regulatory community anticipated. Whether or not it was reasonable for the Fed or otheragencies not to see the danger inherent in the explosive growth in unregulated OTC derivativesand unregistered, opaque complex structured assets markets is another matter. viMason describes the situation at the OCC in a 2008 interview: “The subprime crisis results from a growing arbitrage of regulations and accounting rules that got out of hand. Right now the situation is that regulators dont want to acknowledge the problems in the market because to do so is to admit that they missed these same problems, in some cases going back 30 plus years now. They cant admit the problems without admitting malfeasance. On top of that, its an election year which really throws

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5 things for a loop. And then of course notwithstanding the fact that the regulators have egg of their face, the ratings agencies dont want to make any changes because, for them at least, this world is working just fine.” viiDuring the past two decades, the proliferation of off exchange-traded derivatives and the use ofoff-balance-sheet entities (à la Enron) have been actively encouraged by the Congress, theFederal Reserve Board staff in Washington and other global regulators. The combination of OTCderivatives, risk-based capital requirements authorized by Congress in 1991 and favorableaccounting rules blessed by the SEC and the FASB, enabled Wall Street to create a de factoassembly line for purchasing, packaging and selling unregistered securities, such as subprimecollateralized debt obligations (CDOs), to a wide variety of institutional investors. viiiEuropean observers aptly describe the literally thousands of CDOs and other types of structuredinvestment vehicles (SIVs) created during the past decade as a “shadow banking system,” butfew in the U.S. appreciate that this deliberately opaque pseudo market came into existence andgrew with the direct approval and active encouragement of Greenspan, and other senior bankregulators in the U.S. and EU. Moreover, all of this occurred with the encouragement andapproval of the academic research community. Regulators even issued cautionary guidance tohelp the dealer firms manage the quite apparent operational risks from dealing in complexstructured assets, but did nothing to stop the financial services industry from creating this hugeunregulated securities market. ixSeen from the perspective of regulatory inaction, the true lesson of the subprime crisis has less todo with the use of subprime mortgages as collateral in the SIVs and much more with how theseinferior assets were packaged and sold outside the bounds of established regulatory controls.Not only did regulators allow the creation of new, unregistered assets classes which have causedinvestors grievous losses, but the use of structured finance by banks for reasons of fundingintroduced a new element of volatility and instability into the model of many U.S. bankinginstitutions.The growth in the “markets” for OTC asset classes and related phenomena represents a reversalof nearly a century of regulatory and prudential practices in the U.S.. Following the financialmarket crises of the 19th and early 20th centuries, the U.S. Congress substituted personal marketdiscipline for regulation. x The U.S. put in place legal strictures and market guidelines thatrequired virtually all financial instruments to be traded on exchanges, with price discovery andcounterparty credit risk issues exposed to the full light of public scrutiny and, thus, marketdiscipline. However, with the “Big Bang” of decimalization in March 2001, the sell-sideconsensus surrounding the exchange-traded model, which already was under pressure,completely unraveled. xiWhile retail investors realized big savings in terms of the cost of execution after decimalization,the Big Bang also ripped the profitability out of institutional trade execution, forcing the majorWall Street firms to strip the services provided to investors down to the bare bones. More thanthe restrictions of Regulation FD or threats of prosecution by former New York State attorneygeneral Elliot Spitzer, decimalization forced spreads to shrink and gradually compelled many

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6large sell-side firms to cut back on research and banking coverage for issuers of public securitiesand to focus new investments on OTC asset classes.Post-decimalization, trading and sales of stocks and bonds were no longer profitable for manysecurities firms; thus, the only way to enhance or even maintain profitability was — and remainstoday — to employ lots of leverage – 30:1 debt to equity or more – and focus on OTC assets. Inthe shadowy world of OTC structured assets, bid-offer spreads are much wider than onexchanges because of poor transparency and disclosure. It helps if you think of the OTC marketfor derivative securities as comparable to the market for precious art, where the assets are allunique and pricing is rarely disclosed, except between dealers and clients. Further complicatingmatters, because OTC assets like CDOs often carried investment-grade ratings purchased fromratings firms, these less liquid assets carry lower risk-based capital requirements than otherassets! Again, the operative mission is regulatory arbitrage. xiiMany CDOs are entirely synthetic, with no collateral, supporting the gaming metaphor. Becauseno contract is comparable to another and because participants can “write” unlimited amounts ofdefault protection without any margin requirements or reserves, pricing for these custominstruments is entirely relative and uncompetitive, and the potential to multiply the basis riskused to define a given transaction is open-ended.It is no accident, then, that since 2001, the massive growth in the number of hedge funds and theassets these vehicles control also spiked, as broker dealers used their own balance sheets to boosttrading volumes and to widen spreads in OTC products. To be fair to Greenspan and theregulators, the major derivative dealer firms share the largest part of the blame for the subprimecrisis.Indeed, as 2008 began, many prime brokers were forcing hedge fund clients to reduce leverageand thereby the amount of assets that the dealers need to finance — assets that the dealers, infact, own. Once seen as a source of double-digit returns, hedge funds are now viewed by dealersas sources of open-ended liability.With the failure and sale of Bear, Stearns & Co, the process of deleveraging on Wall Street islikely to accelerate, begging the question as to whether many hedge funds will not be forced toshrink or liquidate entirely in an environment where leverage ratios are well-below the doubledigit levels seen in the past five years. xiiiFair Value AccountingA third significant factor in making the collapse of the market for structured assets containingsubprime debt a true catastrophe is the move to fair value accounting, a process that wasimplemented last year but has been debated for more than a decade. “Fair value” accounting is anew era notion that has developed over the past two decades and was promoted by largesegments of the accounting and economics profession, as well as by leaders of the financialservices community. It was implemented last year by an arm of the SEC known as FASB or theFinancial Accounting Standards Board.

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7I don’t know many people who expect accountants to destroy the world, but the good people atFASB are coming pretty close to doing just that. Fair value accounting is driving and increaseinvestor fears about the solvency of many financial institutions.Understanding the common intellectual lineage of efficient market theory and fair valueaccounting is crucially important. Going back decades, economists argued that securitized assetssuch as those developed by the GSEs would be more transparent, and thus more efficient, thanbank assets. It was consequently expected that as the securitization market grew beyond themarket for agency paper, the market would be liquid and transparent. The intermediary role ofthe commercial banking industry would decline and banks would instead focus more and moreeffort on acting as agent and sponsor for these assets.As with efficient market theory generally, fair value accounting assumes a high degree ofliquidity and stability in all markets. As columnist Allan Sloan said to me last week: “If marketswere as efficient as academics suppose, then neither of us could make a living.” Watching lastweekend as JPMorgan Chase agreed to acquire Bear Stearns for $236.2 million, or $2 a share,about 1 percent of the banks value two weeks before, suggests that perhaps efficient markettheory has its limits.Bert Ely, a Washington-based accountant and banking expert, says that the rapid acceleration offinancial technology created classes of assets that neither the Federal Reserve nor the otherregulators ever anticipated —or understand even today. Unlike fairly simple GSE obligations oreven interest-rate swaps (which are entirely standardized and thus quite liquid), CDOs and othertypes of OTC derivatives blossomed into hideously complex and opaque permutations,configurations that a smart trial lawyer might successfully argue were deliberately deceptive.In place of the implicit guarantee of the U.S. Treasury, Wall Street substituted a paid rating fromMoody’s or S&P, as well as a guarantee from a thinly capitalized bond insurer such as Ambac orMBIA. Whereas the intellectual authors of structured finance anticipated that these new eraassets would be highly liquid — for example, qualifying for Level One status under FAS 157 —instead Wall Street created an entirely illiquid market of unique assets that qualify only for LevelThree treatment under the FASB rules. xivMost recently, fair value accounting was pushed by the very same Wall Street firms that wantedto support and nurture the OTC market for structured assets. After all, what better way tovalidate and protect the wider spreads and profitability of OTC asset classes than to giveinvestors greater comfort when it comes to valuation, especially for assets that carriedinvestment-grade ratings and third-party guarantees from the major bond insurers? Thecombination of an external rating, third-party guarantees by monoline insurers and fair valueaccounting provided the necessary ingredients for investors to overlook the obvious liquidity riskdefects inherent in CDOs and other complex structured assets.While Chairman Greenspan initially opposed fair value accounting, it was actively promoted byeconomists at the Federal Reserve and other global regulatory agencies that were proponents of

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8the risk-based capital requirements that are embedded in the Basel II capital framework. The“fair value” of assets is now a key part of the capital adequacy analysis of U.S. banks — a factthat has caused many practitioners to complain that Basel II may result in higher capital chargesfor many assets.The very same visionaries who believe (mistakenly, in this author’s view) that different types ofrisk can and should be parsed into separate buckets, measured accurately and then used tosupport bank safety and soundness have instead created a framework (Basel II) that is arguablyineffective and conflicts with traditional regulator benchmarks, such as leverage ratios. Bankslearned very quickly how to game the risk- based capital regime — e.g., the use of SIVs to moveassets off balance sheet — and all with the blessing of regulators and the FASB.It is no small irony, then, that the positive public policy goal of providing a more flexible way ofdescribing the value of different types of assets (i.e., the shift to fair value accounting) has nowbecome a Draconian regime that is forcing banks and some investors to write down CDOs andother types of derivative assets entirely, even though the assets have not yet reached levels ofdefault that would justify even a modest haircut! Two factors — the near-zero liquidity instructured assets and the severe legal strictures of Sarbanes-Oxley — have forced banks to taketotal losses on assets that were once a source of enormous profitability but lacked organized anddefined markets to ensure liquidity.Part of the reason that companies for centuries used “book value” (e.g., historical costaccounting) to describe the value of assets is that book value accurately reports the cost of theinvestment. Once an investment is made, the only way truly to determine, on an arm’s lengthbasis, the value of an asset is to sell it to a third party. Unfortunately, since there currently is nomarket for CDOs and other structured assets, banks have no choice, under the fair valueaccounting rules, but to take a near total loss — even though the economic value of the assets interms of cash flow may be closer to par!Ely and other observers believe that banks and other investors are overreacting to the subprimedebacle and that many investors will not know the true economic cost of the crisis in the marketfor complex structured assets for more than a year. But what is clear is that the change to fairvalue accounting has turned the subprime crisis into a frightening debacle that threatens thesafety and soundness of some of the largest U.S. commercial banks – perhaps needlessly.At a meeting of nearly three dozen chief investment officers from the insurance sector last week,one CIO described spending 10x as much time and internal resources on the investment sectionof his firms audit vs. 2006, in large part because auditors are forcing a "fair value" review of allilliquid assets.Another CIO describes how investment decisions increasingly are being driven by accountingrather than economic concerns. "We have assets that are not impaired, that are still paying, butour auditor made us write off the full value," notes the CIO, who adds that his auditor has beenattempting - unsuccessfully - to get brokers to attest in writing as to the pricing of illiquid assets.

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9Early in 2008, Citigroup reported an $18 billion write down from structured assets, and wasdesperately seeking to raise new capital as further credit and valuation losses loom in 2008. Inthe absence of fair value accounting, the tens of billions of dollars in trading book losses reportedby Citigroup, Merrill Lynch and other global investment firms might have been greatly reducedor avoided entirely.Sylvain Raines, a lecturer at Baruch College in New York, told a meeting of the ProfessionalRisk Managers International Association last September: "The Chicago School of Economics hasbeen telling us for a century that price and value are identical, i.e. that they are the same number .. . If we do not recognize the fundamental difference that exists between price and value, then weare doomed." xvWhile the subprime fiasco may cause the insolvency of a large commercial bank during 2008,the survivors may be able to report extraordinary gains on these same written-down assets oncethe current investor hysteria passes. As and when the dealer community and their patrons inWashington make adjustments to the structured asset business model, much of the paper nowviewed today as toxic waste may actually be quite valuable.Subprime EffectsU.S.-based credit watchdog S&P said last week that total losses to be booked by the globalfinancial sector from subprime asset-backed securities could reach $285 billion, but opined thatthe end of write downs was now in sight for large financial institutions. xvi However, the loandefault activity of U.S. banks suggests that the bottom in the real estate market is not yet in sight.Let’s consider some of the macro effects of the subprime crisis:The Banking Industry • Immediate: Subprime crisis tears gaping hole in bank business models, eliminating volume and income while limiting ALM options. Net effect is large % reduction in credit available. • Long-term: The clock has been wound back decades. Loan origination now implies retention of the asset as default option. Banks have limited funding, revenue options.Risk Preferences • The subprime crisis has changed investor and lender preferences dramatically. Structured assets of all ratings grades are being shunned in favor of simpler cash securities. Dealers are walking away from low-risk markets such as Munis due to concerns about capital availability and “fair value” risk.

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10 • As the Bear, Stearns collapse illustrates, there has been a huge reduction in market liquidity overall, and with this a sharp decrease in leverage used by all market participants.Litigation • The subprime crisis has made lenders and their advisers extremely vulnerable to a number of different types of claims. Borrowers are bringing claims against lenders for violations in TILA as well as loan suitability rules. End-investors are likewise suing lenders, dealers and rating agencies for fraud, KYC suitability of complex structured assets.The Economy • The forced liquidation of some $3 trillion in private label structured assets is depriving the financial markets and the U.S. economy of a vast amount of liquidity that the banking system simply cannot restore.ConsequencesIt is worth noting that housing prices are generally lagging indicators, suggesting that the bottomin the U.S. housing market probably lies in 2009. No amount of Fed interest rate ease canchange that fact that reviving the housing market means that affordability must be restore tohome valuations; that is, prices must fall substantially in many markets.Let’s take a look at some examples from the banking industry data collected by the FDIC to seewhere the U.S. banking system is today in the adjustment process and speculate about futurelevels of loan defaults. • The first table in the Appendix to this paper shows that the banking industry as a whole has seen a dramatic slowdown in terms of profitability and a rise in non-current assets and other real estate owned or “OREO.” The performance numbers for all banks are clearly deteriorating, but the industry is not yet near a crisis. • Chart 1 in the Appendix shows gross loan charge-offs or defaults for Citibank NA and its large bank peers. Notice that despite almost a year of market turmoil regarding the credit quality of subprime assets, large bank default rates remains quite low. As the rate of bank default experience reverts to and then exceeds the long-term averages, the U.S. banking industry will face its greatest financial challenge since the early 1990s and possibly the 1930s. • Chart 2 in the Appendix shows gross loan charge-offs or defaults for Washington Mutual Bank FSB and its large bank peers in the mortgage specialization peer group. Notice the sharp increase in the WaMu charge off performance after the close of the 2005 acquisition of the subprime credit card issuer Providian. In 2007, WaMu’s credit card portfolio reported 1,000 bp of charge offs to the FDIC.

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11 • Chart 3 in the Appendix show gross loan charge-offs or defaults for FIA Card Services, the $170 billion asset credit card unit of Bank of America that includes the former MBIA business. Notice the huge spike in peer group default rates in the 2002 period, which was caused by an 8-10% write-down by several other banks.Given the magnitude and duration of the trough in bank loan default experience in the 1993-2001period and the 2004-2007 period, and given the magnitude of the increase in real estate prices inthe past seven years, it seems reasonable to conclude that the upward swing in loan defaults nowunderway will test or exceed recent peaks. The 340bp of default realized by Citibank NA in1991 threatened that bank’s solvency, thus a 2008-2009 bank loan default peak of say 2x 1991levels would create a broad systemic financial and economic crisis.A Free Market Solution: Extinguish the GSEsThe trouble with all of the actions by the Federal Reserve and the Bush Administration’sproposals to date to address the subprime crisis is that they ignore the underlying causes and donothing to improve investor sentiment regarding structured assets. Fixing the problem is goingto take a concerted effort by the major dealer firms and the regulatory community — an effortthat so far is missing necessary leadership from Washington and Wall Street.Federal bank regulators such as Fed Chairman Ben Bernanke show little political appetite forconfronting the Congress regarding its infatuation with housing policy as a means of buyingvotes. And political appointees such a Treasury Secretary Hank Paulson, the former CEO ofGoldman Sachs (NYSE:GS), seem strangely detached from events.During March of 2008, I had an email exchange with several CEOs of bulge bracket firms,essentially asking "Wheres the plan?" from the private sector to address investor angst overilliquid securitized assets. The response was uniform and limp: we have to fix the ratingsagencies first, a reply that basically suggests that Buy Side investors are mindless idiotsincapable of making asset allocation decisions without guidance from Moodys (NYSE:MCO) orS&P, a unit of McGraw Hill (NYSE:MHP).Such a response is disappointing, but hardly surprising. Corporate CEOs are no more willing togo to bat for free market principles than are members of Congress or the Cabinet. Yet thecollapse of the market for private label structured assets presents an opportunity for privateissuers and investors who are willing to take advantage of the current market dysfunction.Indeed, the impending insolvency of both Fannie Mae (NYSE:FNM) and Freddie Mac(NYSE:FRE) may present a way to solve a big part of the problem with the U.S. housing financesector, namely the hegemony of the U.S. government in mortgage securitization.My friend Bob Feinberg likes to quip that the government-sponsored entity or "GSE" is now thefavored model in Americas supposedly free market economy, a telling comment for thosefamiliar with European history. After all, FDRs inspiration for using the GSE model during the

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12Great Depression came from earlier experiments in fascist Italy and Germany, a model clearlyantithetical to a democratic, free society, much less a market-based economy.Professor Joseph Mason suggests the ultimate cause of the subprime mess is the growinggovernment monopoly over the fat middle, low-risk portion of the U.S. housing market. Byleaving the least attractive scraps of the mortgage finance sector to the private banks, whichmimicked the GSEs securitization template in an effort to compete, Washington actually createdthe current crisis in subprime securitizations. If true, the failures of entrepreneurial privatecompanies such as Countrywide Financial and Bear, Stearns & Co. may owe their origins to theinvisible hand of Washington – a disturbing possibility. In future, it may not be possible forrelative outsiders like a Countrywide or Bear to break into the cartel of large banks that controlthe world of institutional capital finance.The Street, however, now has a rare opportunity to recast the current market structure, strike ablow for the national interest and make money at the same time. The false promise of private"credit enhancement" has distorted investor behavior, but balance is returning. Now thatunderlying credit quality of collateral in private label securitizations is the focus of investoranalysis efforts, the markets are moving toward clearing, but help is needed in order to giveinvestors the comfort they require to get back into the game.Somewhere between the fantasy land idea of "AAA" ratings for subprime debt (defined as paperthat routinely throws of 20-30% defaults over say three to five years) and default is a price wheresuch deals get done, without credit enhancements or third-party ratings. Incidentally, thats whymy firm subjects U.S. banks to a 1,000 basis point or 10% default tolerance threshold in theEconomic Capital model in The IRA Bank Monitor. Finding that market clearing price level isthe start of a true solution - maybe even a revolution.When, not if, the wave of defaults and foreclosures in conforming mortgage paper hits the GSEs,the Congress and a new President will confront a huge public sector bailout. But rather thanwatching Washington further nationalize the housing finance market, the true underlying causeof the subprime crisis, both sides of the Street should organize and be prepared to bid against are-nationalization of FNM and FRE. If investors could stop worrying about what the Fed is goingto do or whining for a bailout from Congress, we might actually solve this problem and thensome."Do you think Wilbur Ross would pay 5x tangible book for Freddie," asked my friend andcolleague Josh Rosner. Ross, for those of you how don’t know the name, is an astute vultureinvestor who has been accumulating real estate assets on the cheap, most recently in the case ofthe purchase of H&R Block’s Option One mortgage servicing portfolio.Rosner figures that "tangible" book for FRE is $0.46 per share, so figure $2.50 per shareincluding the tip, about sharp discount from the current market value. Remember that the bondholders are the true shareholders of both GSEs. GSE equity is just an option. By Election Day,defaults and mounting OREO could see both GSEs trading in single digits - if they are trading atall.

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13By being prepared to float a private rescue of FNM and FRE, an organized, coherently ledconsortium of private banks, dealers and investors could be in a position to propose to theCongress a grand concordat, a systemic fix to the current mess that also could help restore freemarket discipline to Americas increasingly managed financial markets. The executive summaryof such a plan reads like this: • Repeal of fair value accounting treatment for illiquid financial assets. xvii • Standardization of terms and structure of all private label securitizations. • Registration with the SEC of all securitizations to be sold to banks/pension and/or mutual funds. • Public disclosure of secondary market prices for all securitization and OTC derivative transactions.The Street would bid for the assets and guarantee portfolios of FRE and FNM, and use this vastcorpus of deeply discounted "conforming" assets as the foundation for a much larger, purelyprivate securitization market that includes all manner of collateral. A new definition of"conforming" paper would be established for all private securitizations, which may or may notcarry ratings or enhancements. The Congress would codify the new standard intolaw, extinguish the corporate charters of FRE and FNM, and refocus public policy on thesubprime area via Ginnie Mae where there is arguably a role for direct government assistance.Why now for such a bold plan? Well, for starts Uncle Sam is broke. Given current Fed interestrate policy, the war in Iraq and a widening recession, the mere suggestion that the Congress isconsidering a public bailout of the GSEs would send the dollar into a free fall that makes recentmarket weakness seem leisurely by comparison. Fears of inflation and growing state-interventionin the U.S. economy would turn the dollars slump into a rout. How does $3 per Euro strike you?When the market value of the GSEs begins to approach "tangible book," the Street has a rareopportunity to roll back Washingtons intervention in the U.S. mortgage market and eliminateone of the worst socialist excesses of the New Deal. The missing ingredient, at the moment, isleadership and imagination from the captains of Wall Street, who have been far too comfortablewith the status quo. Even usually conservative voices like Barrons incredibly call the prospectof nationalization of the GSEs "a good thing."The good news, though, is that theres plenty of private capital on the sidelines waiting fordirection. Can the heads of the major Buy and Sell Side houses summon the necessary courage,brain power and attention to suggest a private sector solution to the subprime crisis? Is thereenough courage and self interest on Wall Street to challenge the political equation inWashington? Such an audacious course could reduce the role of government in mortgagefinance, takes financial pressure off our spendthrift government and may even help the battereddollar. But most important, it will revive a financing mechanism that is vital for U.S. economicgrowth, namely the market for private label structured assets.

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16Chart 3 Gross Defaults (bp)Source: FDIC/IRA Bank MonitorEndnotesi This paper is based on an earlier article which appeared in the Jan-Feb 2008 issue of GARP Risk Review andcomments excerpted from The Institutional Risk Analyst.ii See Mason, Joseph, “A National Homeownership Strategy for the New Millenium,” Market Commentary,February 26, 2008. (See: http://www.criterioneconomics.com/docs/)iii “GSE Nation: Interview with Robert Feinberg,” The Institutional Risk Analyst, March 17, 2008iv For a complete summary of Rosner’s comments, see “The Subprime Crisis: PRMIA Meeting Notes,” TheInstitutional Risk Analyst , September 24, 2007. In 2007, approximately 110.3 million housing units were occupied:75.2 million by owners and 35.1 million by renters or some 68% owner occupied. This compares with some 63%owner occupied in the early 1990s measured against a smaller population and housing inventory.v See Rosner and Mason, “How Resilient Are Mortgage Backed Securities to Collateralized Debt Obligation MarketDisruptions?” The Hudson Institute, February 15, 2007.vi See Whalen, Christopher, “New House Rules: How the Feds Are Seeking to Make the World Safe forDerivatives,” The International Economy, (Summer 2004): 54.vii See “No True Sale: Interview with Joseph Mason,” The Institutional Risk Analyst, March 3, 2008

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17viii The Federal Deposit Insurance Corporation Improvement Act (FDICIA) required banks to use risk-based capitalrequirements to measure capital adequacy in a prelude to the Basel II framework.ix See “Interagency Statement on Sound Practices Concerning Complex Structured Finance Activities,” FederalRegister (May 19, 2004).The statement has since been amended. Notice that the SEC and federal bank regulatorguidance is “suggested” only and has no force of law, either for safety and soundness purposes or to support civilfraud claims.x Prior to the 1930s, investors in U.S. banks had double liability for their investments and had to be prepared toinvest an additional dollar for each dollar in shares held. With the reforms of the 1930s, however, Washington tookexplicit responsibility for bank safety and soundness.xi The SEC issued an order requiring all U.S. exchanges to implement decimalization on June 8, 2000. Seehttp://www.sec.gov/rules/other/34-42914.htm.xii The case of Citigroup’s initial support for its foundering SIVs in mid-2007 is a case in point. Rather than providedirect loans to the SIVs to finance client redemptions, Citigroup reportedly purchased the “AAA” rated paper itselfand thereby held an asset with the lowest possible risk weighting! This façade, however, was abandoned later in2007.xiii It is typical for hedge funds and broker dealers to run at capital to debt ratios of 30:1. In order for a hedge fund topay investors a 10% return under the standard 2% of assets invested and 20% share of profits fee structure, mosthedge funds must earn 20% annualized returns. As of February 2008, the Credit Suisse/Tremont Hedge Fund Indexshowed a 1-Year Return of 10.3%.xiv Level One assets are those for which publicly quoted prices are available. Level Three is for illiquid assets forwhich there is no public market. See “Summary of Statement No. 157”(http://www.fasb.org/st/summary/stsum157.shtml).xv For a complete summary of Raines comments, see “The Subprime Crisis: PRMIA Meeting Notes,” TheInstitutional Risk Analyst , September 24, 2007.xvi See Edwards, Andrew, “S&Ps Subprime Report Sees Pain, Hope Ahead,” The Wall Street Journal, March 14,2008xvii See Whalen, Christopher, “Banks wallow in the muddy waters of fair value rules,” Financial Times, March 6,2008.